Alaska Air Group is an industry leading airline ranked higher than peers.

The merger process with Virgin America is almost complete and will begin realizing cost synergies.

U.S. Airlines are striving to achieve higher profitability in 2018, but are encountering a tough fuel market.

Financial performance in the last year has not been the best; however, I believe shares have a ~ 6% return opportunity from current price levels.

Synopsis

Alaska Air Group, Inc. (NYSE: ALK) is an airline holding company that offers cargo and passenger air transportation services. The company has three subsidiaries that are composed of two associated airlines, Alaska Airlines and Horizon Airlines. The company also operates McGee Air Services as an aircraft services enterprise that runs ground handling services, aircraft cleaning and wheelchair assistance to variety of airlines.

Alaska Air announced the acquisition of Virgin America on April 4, 2016 for roughly $2.6 billion and they closed the deal in December of the same year. Virgin America and Alaska Airlines were operating separately until March 22, 2017. Alaska Air Group made public their decision to unite both Airlines and combined operate under the Alaska Air brand, which is recognized worldwide for its excellent service, security and sustainability.

The integration process is still ongoing and the company is beginning to see synergistic cost savings across multiple departments, with $65 million expected in 2018 in the passenger service system “PSS”. The acquisition increased headcount above 3000 and was very important the Alaska’s overall strategy to expand their presence across the US and Latin America.

At present, Alaska Airlines manages 118 destinations between United States, Canada, México and Costa Rica. The company has plans to expand their service to additional locations in the US.

U.S. Airline Industry Struggling

2018 has not been an easy year for the industry because operating margins have decreased due to rising oil prices. Decreasing margins are making profitability tough, as a result the IATA (International Air Transport Association) decreased the profit forecast $4.6 billion from $38.4 billion to $33.8 billion and cited rising oil and labor costs as a contributing factor.

Airlines are reorganizing cost structures and implementing hedging strategies that were historically minimal during the 2016-2017 bear market in crude. The Industry is adapting by raising fees and passing the increasing costs off to customers. Fees are increasing on baggage, food and fares. Within the last few weeks, United (UAL) and JetBlue (JBLU) raised their baggage fees on domestic routes by $5 for the first checked bag. The trend is for increasing baggage fees as American Airlines (AAL) and Delta Airlines (DAL) raised their transatlantic routes baggage fees to $60. Alaska has not mentioned any plans to raise the baggage fees but it remains a possibility as fuel prices continue to rise.

The Merger

The U.S. Airline industry has been experiencing headwinds over the last decade and undergoing a period of consolidation. Alaska Air is performing in a challenging environment and they are trying to finish the merger as soon as possible and realize cost synergies.

Only 20 months have passed since the acquisition was made and it has been the most rapid merger process in the aviation industry. During the 2nd quarter, nearly 85% of the merger process had been completed. The company is expecting to finish the merger process by the end of 2018. By the end of the 4th quarter, the company expects full integration and deployment of the combined Virgin and Alaska fleet. Alaska Air will capture merger synergies until 2021 and realize significant cost savings.

Management and investors are not completely satisfied with the company’s performance. Merger costs are affecting the profitability of the company and causing management to give conservative estimates surrounding financial performance. Last quarter, the earnings report was mixed because the company beat EPS estimates by $0.03, coming in at $1.66; however, the company did not achieve the analyst consensus revenues of $2.16 billion, coming in $10 million below expectations. Looking towards the second half of 2018, revenues should rise in the low single digits and earnings will negatively impacted by rising fuel prices if the company's hedges don't play out.

Fuel prices are an obstacle to sustained earnings growth

Fuel prices have been gradually increasing for 10 consecutive quarters and they are currently $1 higher than they were in the first quarter of 2016. Since the airlines lifeblood is fuel and they purchase is large volumes, the rising fuel prices are a $850 million cost increase.

(Source: Koyfin)

Early in the decade Alaska Air hedged significantly, but when Brent crude prices dropped in early 2016 they took off their hedges and benefited from historical low Brent crude prices. The company's current strategy is focusing business activities that reduce fuel cost through hedging activities.

Alaska Air is hedging their fuel costs using WTI call options. The company experienced a reduction of $9 million in fuel expenses during the last quarter. The company is hedging 50% of their planned consumption for the rest of the year with a strike price of $67 a barrel. The company is expecting these hedges to reduce risk and save considerable amounts of money in a rising fuel price environment.

Tightening Financial Conditions

In the second quarter, excluding merger-related costs, the company reported an adjusted net income of $206 million and an adjusted EPS of $1.66. Despite the tough fuel market, the company has increased EPS over the past two quarters.

Alaska Air Group has increased dividends for the past 5 years with the most recent increase bringing the quarterly dividend to $0.32. The company has plans to repurchase about $100 million in shares through the rest of 2018 and the strategy to return capital to shareholders is a combined dividend and share repurchase program.

(Source: Koyfin)

Alaska shares have been under-performing the market and have decreased by 11.31% YTD. The benefits from the merger with Virgin America have not been realized yet and there is uncertainty around the true cost savings of the combined airline. The market is looking towards fuel prices and how the airline will cope with rising costs. If the company can effectively hedge their costs, the share price stands to benefit in the second half of 2018.

(Source: Koyfin)

Revenues appear to have flat lined in the near term, but this trough appears will likely be overcome as the company expects to higher revenues and margins in the second half of the year and into 2019.

The company is continuing to experience positive free cash flows and excluding the merger-related costs, the total cash flow for the first half of the year was $800 million. After you subtract out the capex, the free cash flow is $375 million.

(Source: Koyfin)

During the first half of the year, the dividends paid by the company were more than $100 million and with the buyback the total capital returned to shareholders is expected to run towards $200 million on the year.

Valuation

(Source: Koyfin)

The 5.8x forward looking EV/EBITDA seems in line with peers as the airline industry trades to a below market EV/EBITDA multiple.

(Source: Koyfin)

Based on cost synergies the merger will provide and the company's ability to sustain profitability in a tough fuel price environment, I derive a $73 price target. My price target implies a 5.7% discount to fair value from the current price levels.

Some metrics supporting my valuation include:

The ability for the airline to sustain profitability in a rising fuel price environment and effectively hedge fuel price risk.

The cost synergies being accretive to earnings over the coming years.

How to play the stock in options

Strategy: Vertical Bull Spread

The goal of this strategy is to use the options market to reduce the capital outlay and provide upside stock exposure. If the share price turns down due to rising fuel prices or an unforeseen event, the maximum loss will be limited.

The options pricing model indicates 33.25% of total pricing movement will produce maximum profit for the trade, with nearly 9.83% of outcomes producing the some profit. The options pricing model indicates 46.27% of pricing outcomes will produce a maximum loss situation. I like this trade on Alaska because the stock only needs to rally roughly 4% from current share price levels to create a maximum gain situation. If the share price goes through a period of consolidation and falls, you are limited on the amount of capital you can lose.

Buy the $67.50 call option for $325 premium with an expiration date of October 19th.

Sell the $72.50 call option for $95 premium with an expiration date of October 19th.

The share price needs to be at or above $72.50 at expiration on October 19th to make the max gain of $270.

If the share price is below $67.50 at expiration on October 19th, you lose $230.

(Source: Thinkorswim)

Options trading involves risk

Options trading is not for everyone, and this strategy is for experienced investors. I highlighted this strategy to show a unique perspective to lock in stock gains and give the investor upside exposure. If you have any questions about how to implement this strategy, contact a finance professional for guidance.

Disclaimer: Copper Canyon LLC is a Registered Investment Advisor in Orlando, Florida. We have outlined our market commentary, and all information detailed in this article is not investment advice; it merely indicates the opinions and views of Copper Canyon LLC and its Investment Advisors. Any forward-looking statements or share price calculations should not be construed as Investment Advice and are for market commentary purposes only. Forward-looking statements are not indicative of future performance and cannot be interpreted as such. We have no responsibility to update any forward looking statements. This commentary was created by Dylan Quintilone, Investment Advisor Representative of Copper Canyon LLC. Copper Canyon LLC is a State of Florida Registered Investment Advisor.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.